Considering that almost every country in the world suffers from the same magnitude and times of inflation growth, it's kind of risky to consider this hypothesis. Even arguing that the theory only applies to the US, it isolated the phenomena from the complexity of a global economy exogenous cause. In the other side, arguing that inflation in the whole world also is a phenomenon of endogenous causes of public debt, it's also risky because lots of government's before pandemic also suffered from heavy fiscal deficits and don't turn into inflation so seriously like this one.
But probably the more complicated assumption is that in the scenario where investors sold their bonds for the risky repayment promise, the investors will spend the cash in consumption of goods and services and not in another interest bearing assets.
Thank you for this insightful post. My understanding of the fiscal theory of the price level is much more complete now. The idea that higher interest rates in the 80s could successfully combat inflation only because they were accompanied by the promise of future fiscal surpluses (in the late 90s) is (plausible) news to me. Rising expectations of future GDP growth in the 80s seems like the missing variable here.
Two requests: first, a question (hopefully not too ignorant) that I would gladly see answered in a future post. Does the rise of new currencies (bitcoin obviously) diminish the government's ability to inflate away the debt? I mention this because to date the US faces fewer fiscal spillovers than smaller countries when it comes to conducting monetary policy. For an example, consider that nominal interest rates on GBP exceed dollar interest rates. Then no-arbitrage tells us that the pound must depreciate against the dollar. This would raise consumer prices on imported goods, thus further fueling inflation (something to be added to the list of fuels you mentioned). I wonder: will the US government be similarly affected by the rising competition with digital currencies? And a more shallow follow-up: Assuming the expectation of rising bitcoin prices is rational, what does this tell us about investors' expectations over future government debt? My second request: what do you think are the most urgent questions (especially on the theory side) young researchers should tackle to advance the FTPL?
To first order, bitcoin or even stable coins don't affect the value of the dollar in FTPL. The former might compete with and the latter add to a liquidity value of the dollar, so help to raise or reduce inflation. But that's a second order effect. It's much like the gold standard If the dollar is tied to gold, substitutes will change the quantity but not the price.
Technicality: Figure 3 shows twice - also as figure 4 in my version (of course the PDF gets it right).
Fiscal theory "forgets" distributional effects and the monopolist (government) attitude towards tax collection. In the real-world taxes are almost always not uniform. If the monopolist is rich and benefits from lowering taxes inflation gets worse. As the monopolist forces lower rate we will get more inflation. Bottom line: Fiscal theory must dive deeper into the stability and consistency of the tax system (get some public finance extension). Government bonds are just one side of the equation.
Please, can you apply your model to some other countries and not only to the US.
Like Germany or Russia ran consistent surpluses or current China that is rapidly increasing deficits and decreasing tax collection but has a deflation.
Hi Professor Cochrane, following along in the last section of the essay then - given the current path of little reform in entitlements and tax cuts as opposed to raising of tax revenue, is the outlook for the US dollar then necessarily bleak?
Inflation. Here I used CORESTICKM159SFRBATL, the commonly cited change in prices from previous years, as percentages (e.g., 2.0 = 2%). Because this measure reflects price level changes over a full year, computed lag factors will show values 6 months longer than the average timing of price level effects. Thus, independent variable lag factors shorter than 12 months suggest more immediate effects. It is hard to imagine realistic lags of less than a half year because that would mean seeing year-over-year effects from events near the end of a 12-month period. Thus I did not allow the program to examine lags shorter than 6 months.
1. Domestic Liquidity Ratio. This is the ratio of money supply to GDP. Since GDPC1 (Billions of Chained 2017 Dollars, Seasonally Adjusted Annual Rate) is only available by quarter, I used a simple three-period filter to tease out a monthly number. For money supply I used M2REAL (Billions of 1982-84 Dollars, Monthly, Seasonally Adjusted).
2. Federal Funds Rate. I used FEDFUNDS from FRED, after subtracting the inflation rate, to get REAL rates.
Before running these two alone, I added the following three, and tested lags in one month intervals. Did 94,000 regressions to check all combinations. I remember at NPS turning in a card deck to do one. At NYU I could dial in and run one, if I had the patience. It's a new world.
Tariff Revenue. I tried B235RC1Q027SBEA (Federal government current tax receipts: Taxes on production and imports: Customs duties). I used a simple three-period filter to tease out a monthly number and inflated this series based on CPI adjusted to 2025-01-01.
Federal Deficit Spending. I tried Fed SURP-DEFMTSDS133FMS (Fed Surplus/Deficit (Millions)), changed the signs to make deficits positive, scaled all values to trillions of dollars, and set all surplus values to zero. I inflated this series based on CPI adjusted to 2025-01-01.
Unemployment Rate. I tried UNRATE (The number of unemployed as a percentage of the labor force) without modification, as a percentage.
Federal Funds Rate. I used FEDFUNDS from FRED, after subtracting the inflation rate, to get REAL rates.
Initial Results with 5 independents:
Real Fed Rate: lag 22 months, coefficient 0.33 t 25.7
Unemployment lag 6 months, coefficient -0.17 t =9.40
Liquidity Ratio: lag 23 months, coefficient 0.288 t = 25.838
Deficit Spending: lag 9 months, coefficient-0.001 t = -3.8
Real Tariff Revenue: lag 6 months, coefficient -0.014, t = -2.758
Constant: coefficient-2.31, t = -2.758
Then I ran the final regression, omitting one variable at a time. The two omissions that had any effect on the original 0.75 adjusted R-squared were Real Fed Rate and Liquidity Ratio, also the only two with long lags. Using those two gives:
Regression Equation:
ANNUAL INFLATION = -2.9763
+0.3616 x REAL FED FUNDS RATE (LAGGED BY 20 MONTHS)
thinking of Stablecoins as new form of money creation, and coming velocity thereof.
Aside from the populist appeal and sales pitch of how Stablecoins may neuter big banks, and separating payment systems, rails, narrow banks from commercial lending, what are the potential dangers of Stablecoins as a form of new money creation. (Unteatherd :) and Unstable)
Terrific piece. I agree with most of it, but I look at things somewhat more simplistically. That is, in 2020 and 2021 US citizens received $6 trillion in excess spending power in two years (a 40% increase in M2) at the same time that real production declined. Most of this was not spent in 2020, but mostly in 2021 and after. Once the shelves (and auto lots, and housing projects) were cleared at old prices, inflation had to go up. There was never any question of saving. When Americans get free money, they spend it, full stop.
In my opinion, inflation started falling in 2022 because the Fed began reducing its balance sheet with QT and M2 started to decline (withdrawing spending power). At first, they did this by reducing bank reserves until systemic illiquidity drove Silicon Valley out of business. (Oops) After that they used reverse RP.
If the Fed had sold bonds instead of doing QE, I’m sure inflation would not have been so severe. Also, it might have sent long term rates higher which might have prevented the house price bubble from which we still suffer.
The shocking thing to me is why no economist of any persuasion (that I am aware of) predicted serious inflation as late as February 2021. This suggests a radical flaw at the heart of economics.
I would very much appreciate your sending a copy of your excellent article to Sect. Scott Bessent as he seems to be a little confused as to how monetary and fiscal policy operate.
I enjoy the discussion on supply side shock during covid with demand for restaurants vs Pelotons. Reminds me a similar discussion in Arg when the govt eliminated energy subsidies and some people were concerned that inflation will pick up but it mostly reduced demand for restaurants and hotels.
Doesn't intergovermental debt darken the skies further
Considering that almost every country in the world suffers from the same magnitude and times of inflation growth, it's kind of risky to consider this hypothesis. Even arguing that the theory only applies to the US, it isolated the phenomena from the complexity of a global economy exogenous cause. In the other side, arguing that inflation in the whole world also is a phenomenon of endogenous causes of public debt, it's also risky because lots of government's before pandemic also suffered from heavy fiscal deficits and don't turn into inflation so seriously like this one.
But probably the more complicated assumption is that in the scenario where investors sold their bonds for the risky repayment promise, the investors will spend the cash in consumption of goods and services and not in another interest bearing assets.
Figure 4 looks identical to figure 3 to me?
Thank you for this insightful post. My understanding of the fiscal theory of the price level is much more complete now. The idea that higher interest rates in the 80s could successfully combat inflation only because they were accompanied by the promise of future fiscal surpluses (in the late 90s) is (plausible) news to me. Rising expectations of future GDP growth in the 80s seems like the missing variable here.
Two requests: first, a question (hopefully not too ignorant) that I would gladly see answered in a future post. Does the rise of new currencies (bitcoin obviously) diminish the government's ability to inflate away the debt? I mention this because to date the US faces fewer fiscal spillovers than smaller countries when it comes to conducting monetary policy. For an example, consider that nominal interest rates on GBP exceed dollar interest rates. Then no-arbitrage tells us that the pound must depreciate against the dollar. This would raise consumer prices on imported goods, thus further fueling inflation (something to be added to the list of fuels you mentioned). I wonder: will the US government be similarly affected by the rising competition with digital currencies? And a more shallow follow-up: Assuming the expectation of rising bitcoin prices is rational, what does this tell us about investors' expectations over future government debt? My second request: what do you think are the most urgent questions (especially on the theory side) young researchers should tackle to advance the FTPL?
To first order, bitcoin or even stable coins don't affect the value of the dollar in FTPL. The former might compete with and the latter add to a liquidity value of the dollar, so help to raise or reduce inflation. But that's a second order effect. It's much like the gold standard If the dollar is tied to gold, substitutes will change the quantity but not the price.
Figures 3 and 4 appear to be the same figure?? Cut and paste error?
Technicality: Figure 3 shows twice - also as figure 4 in my version (of course the PDF gets it right).
Fiscal theory "forgets" distributional effects and the monopolist (government) attitude towards tax collection. In the real-world taxes are almost always not uniform. If the monopolist is rich and benefits from lowering taxes inflation gets worse. As the monopolist forces lower rate we will get more inflation. Bottom line: Fiscal theory must dive deeper into the stability and consistency of the tax system (get some public finance extension). Government bonds are just one side of the equation.
Please, can you apply your model to some other countries and not only to the US.
Like Germany or Russia ran consistent surpluses or current China that is rapidly increasing deficits and decreasing tax collection but has a deflation.
If inflation is too much money chasing too few goods, it seems to me it could happen in both ways - increase in the money, or decrease in the good.
What am I missing?
Hi Professor Cochrane, following along in the last section of the essay then - given the current path of little reform in entitlements and tax cuts as opposed to raising of tax revenue, is the outlook for the US dollar then necessarily bleak?
I have a model that predicts year-over-year inflation TWO YEARS in the future. There are two independent variables. Adjusted R-squared is about 0.7.
And what is this model and the two variables? Nobody else comes close!
Inflation. Here I used CORESTICKM159SFRBATL, the commonly cited change in prices from previous years, as percentages (e.g., 2.0 = 2%). Because this measure reflects price level changes over a full year, computed lag factors will show values 6 months longer than the average timing of price level effects. Thus, independent variable lag factors shorter than 12 months suggest more immediate effects. It is hard to imagine realistic lags of less than a half year because that would mean seeing year-over-year effects from events near the end of a 12-month period. Thus I did not allow the program to examine lags shorter than 6 months.
1. Domestic Liquidity Ratio. This is the ratio of money supply to GDP. Since GDPC1 (Billions of Chained 2017 Dollars, Seasonally Adjusted Annual Rate) is only available by quarter, I used a simple three-period filter to tease out a monthly number. For money supply I used M2REAL (Billions of 1982-84 Dollars, Monthly, Seasonally Adjusted).
2. Federal Funds Rate. I used FEDFUNDS from FRED, after subtracting the inflation rate, to get REAL rates.
Before running these two alone, I added the following three, and tested lags in one month intervals. Did 94,000 regressions to check all combinations. I remember at NPS turning in a card deck to do one. At NYU I could dial in and run one, if I had the patience. It's a new world.
Tariff Revenue. I tried B235RC1Q027SBEA (Federal government current tax receipts: Taxes on production and imports: Customs duties). I used a simple three-period filter to tease out a monthly number and inflated this series based on CPI adjusted to 2025-01-01.
Federal Deficit Spending. I tried Fed SURP-DEFMTSDS133FMS (Fed Surplus/Deficit (Millions)), changed the signs to make deficits positive, scaled all values to trillions of dollars, and set all surplus values to zero. I inflated this series based on CPI adjusted to 2025-01-01.
Unemployment Rate. I tried UNRATE (The number of unemployed as a percentage of the labor force) without modification, as a percentage.
Federal Funds Rate. I used FEDFUNDS from FRED, after subtracting the inflation rate, to get REAL rates.
Initial Results with 5 independents:
Real Fed Rate: lag 22 months, coefficient 0.33 t 25.7
Unemployment lag 6 months, coefficient -0.17 t =9.40
Liquidity Ratio: lag 23 months, coefficient 0.288 t = 25.838
Deficit Spending: lag 9 months, coefficient-0.001 t = -3.8
Real Tariff Revenue: lag 6 months, coefficient -0.014, t = -2.758
Constant: coefficient-2.31, t = -2.758
Then I ran the final regression, omitting one variable at a time. The two omissions that had any effect on the original 0.75 adjusted R-squared were Real Fed Rate and Liquidity Ratio, also the only two with long lags. Using those two gives:
Regression Equation:
ANNUAL INFLATION = -2.9763
+0.3616 x REAL FED FUNDS RATE (LAGGED BY 20 MONTHS)
+0.2409 x LIQUIDITY RATIO (LAGGED BY 25 MONTHS)
Source | SS df MS Number of obs = 498
---------+------------------------------ F( 2, 495) = 562.93
Model | 518.49691 2 259.248455 Prob > F = 0.0000
Residual | 227.966196 495 0.46053777 R-squared = 0.6946
---------+------------------------------ Adj R-squared = 0.6934
Total | 746.463107 497 1.50193784 Root MSE = 1.4578
----------------------------------------------------------------------------------------------------
| Coef. Std. Err. t P>|t| [95% Conf. Interval] |Coeff x Mean| Share
---------+-------------------------------------------------------------------------------------------
REAL FED| 0.3616433 0.0135752 26.64001 0.000 0.3350359 0.3882507 0.2250654 2.47%
LIQUIDIT| 0.2408600 0.0084310 28.56836 0.000 0.2243353 0.2573848 5.9154460 64.88%
Const | -2.9763248 0.2124161 -14.01176 0.000 -3.3926604 -2.5599892 2.9763248 32.65
It's interesting that raising the Fed funds rate increases inflation a year hence.
Joe
757-303-0167
After I entered a very long reply, I can't scroll to the end. Can you see the whole ting?
Figure 4 is now corrected. (I mistakenly had pasted figure 3 twice). Thanks to all for pointing it out.
Speaking of monetary and fiscal interactions, and allegedly discredited monetarism, listen to this interview today of Charles Calomiris on Stablecoins and Blockchain Gang, revolution in banking and payments systems. https://podcasts.apple.com/us/podcast/hidden-forces/id1205359334?i=1000725489245
In the back of my mind I hear backbeat MV=PY :)
thinking of Stablecoins as new form of money creation, and coming velocity thereof.
Aside from the populist appeal and sales pitch of how Stablecoins may neuter big banks, and separating payment systems, rails, narrow banks from commercial lending, what are the potential dangers of Stablecoins as a form of new money creation. (Unteatherd :) and Unstable)
What are your thoughts?
Terrific piece. I agree with most of it, but I look at things somewhat more simplistically. That is, in 2020 and 2021 US citizens received $6 trillion in excess spending power in two years (a 40% increase in M2) at the same time that real production declined. Most of this was not spent in 2020, but mostly in 2021 and after. Once the shelves (and auto lots, and housing projects) were cleared at old prices, inflation had to go up. There was never any question of saving. When Americans get free money, they spend it, full stop.
In my opinion, inflation started falling in 2022 because the Fed began reducing its balance sheet with QT and M2 started to decline (withdrawing spending power). At first, they did this by reducing bank reserves until systemic illiquidity drove Silicon Valley out of business. (Oops) After that they used reverse RP.
If the Fed had sold bonds instead of doing QE, I’m sure inflation would not have been so severe. Also, it might have sent long term rates higher which might have prevented the house price bubble from which we still suffer.
The shocking thing to me is why no economist of any persuasion (that I am aware of) predicted serious inflation as late as February 2021. This suggests a radical flaw at the heart of economics.
At the risk of immodesty, I might point out that my blogpost from March 2021 DID predict the inflation problem. Pretty accurately, too. https://charles72f.substack.com/p/aint-nothin-but-a-party
Finally, I would be most grateful if you would take a look at my most recent Substack post Vendettanomics: Donald Trump's War on our Economy https://charles72f.substack.com/p/vendettanomics-trumps-war-on-econ
I would very much appreciate your sending a copy of your excellent article to Sect. Scott Bessent as he seems to be a little confused as to how monetary and fiscal policy operate.
I enjoy the discussion on supply side shock during covid with demand for restaurants vs Pelotons. Reminds me a similar discussion in Arg when the govt eliminated energy subsidies and some people were concerned that inflation will pick up but it mostly reduced demand for restaurants and hotels.
Didn't covid reduce \emph{aggregate} supply? Hence price level jumps?.